Research summary

Getting inside the Fed’s head

August 25, 2022

Scenario 1: A hard landing
Figure 1: The Fed could steer clear of a hard landing by pausing planned rate hikes

a. Policy turns out to be too restrictive, forcing the Fed to pause

A dotted line shows the expected trajectory of the federal funds rate, which rises to around 3.8% by the end of 2023 and then stabilizes at around 2.5% from the end of 2025. A solid line shows how the Fed might modify the expected trajectory in the federal funds rate, which rises to around 3.4% by the end of 2022 and subsequently declines to stabilize around 2% by the end of 2026.

b. Inflation falls faster than expected

A dotted line shows the expected trajectory of headline PCE, which declines from 6.3% in June 2022 to around 1.4% at the end of 2024 before moving back to stabilize around 1.5% by the end of 2026. A solid line shows how reaction by the Fed might result in headline PCE declining somewhat less, from 6.3% in June 2022 to around 1.1% at the end of 2024 before moving back up toward 2% by the end of 2028.

c. The Fed avoids a deep recession; it’s a moderate one instead

A dotted line shows the expected trajectory of the output gap, which declines to around –1.5% in 2024 and subsequently improving. A solid line shows how reaction by the Fed might result in the output gap declining more modestly to around –1.2% in 2024 and improving thereafter.
Scenario 2: Stagflation
Figure 2: Persistently high inflation could lead to more aggressive rate hikes and a severe recession

a. The Fed has to tighten more aggressively as it finds itself behind the curve

A dotted line shows the expected trajectory of the federal funds rate, which rises to around 3.8% by the end of 2023 and then falling to stabilize at around 2.5%. A solid line shows how the Fed might modify the expected trajectory in the federal funds rate, which rises to around 5.40% by the end of 2023 and subsequently declines to stabilize around 2.5%.

b. Inflation remains above target for longer

A dotted line shows the expected trajectory of headline PCE, which declines from 6.3% in June 2022 to stabilize at around 3.5% by the end of 2024. A solid line shows how reaction by the Fed might result in headline PCE declining more sharply, from 6.3% in June 2022 to stabilize at around 2% from the end of 2026.

c. This drives the economy into a severe recession

A dotted line shows the expected trajectory of the output gap, which declines to around 0.4% by the end of 2024 and improves thereafter. A solid line shows how reaction by the Fed might result in the output gap declining more modestly to around –1.2% in 2024 and improving thereafter.
Scenario 3: A softish landing
Figure 3: Favorable inflation and output data could allow the Fed to raise rates less than planned

a. The Fed can reverse some of the planned rate hikes

A dotted line shows the expected trajectory of the federal funds rate, which rises to around 3.8% by the end of 2023 and then stabilizes at around 2.5% from the end of 2025. A solid line shows how the Fed might modify the expected trajectory in the federal funds rate, which rises to around 3.4% by the end of 2022 and then declines to stabilize at around 2.5% from the end of 2025.

b. Inflation will converge toward target

A dotted line shows the expected trajectory of headline PCE, which declines from 6.3% in June 2022 to fall below target and then stabilize at around 2% from the end of 2027. A solid line shows how reaction by the Fed might result in headline PCE declining more slowly, from 6.3% in June 2022 to stabilize at around 2% from the end of 2024.

c. A recession can be avoided

A dotted line shows the expected trajectory of the output gap, which declines to around –0.9% by the end of 2024 and improves thereafter. A solid line shows how reaction by the Fed might result in the output gap declining more modestly to around –0.2% in 2024 and improving thereafter.
The path forward
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Contributors

Asawari Sathe
Roxane Spitznagel
Vanguard Information and Insights

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